My most recent books are the Leader's Guide to Radical Management (2010), The Leader's Guide to Storytelling (2nd ed, 2011) and The Secret Language of Leadership (2007). I consult with organizations around the world on leadership, innovation, management and business narrative. At the World Bank, I held many management positions, including director of knowledge management (1996-2000). I am currently a director of the Scrum Alliance, an Amazon Affiliate and a fellow of the Lean Software Society. You can follow me on Twitter at @stevedenning. My website is at www.stevedenning.com.

Understanding Disruption: Insights From The History Of Business

“Every age,” writes Harvard history professor Jill Lepore in her New Yorker article, The Disruption Machine, “has a theory about the past and the present, of what was and what is, a notion of time: a theory of history.”

Can history help us understand Clayton Christenson’s theory of disruption? Lepore’s article gives one set of answers, which I discussed here.

“Before I read this book,” writes W. Brian Arthur of the Santa Fe Institute “I thought that the history of technology was – to borrow Churchill’s phrase – merely ‘one damned thing after another’. Not so. Carlota Perez shows us that historically technological revolutions arrive with remarkable regularity, and that economies react to them in predictable phases.”

Pérez takes a long-term horizon: several hundred years—much longer than either Christensen or Lepore. She draws on many disciplines: history, economics, finance, technology, sociology and management. Ironically, the breadth and depth of the book is one reason why it has been neglected by academics. It’s too bold and wide-ranging for any of them to accept it as “one of theirs”.

The book is guilty of other academic sins. It is clearly written and succinct—a mere 171 pages. And the succinctness is accompanied by precise details on the vast territory covered—the story of capitalism over the last 250 years.

Some repeating patterns throughout history

Pérez’s book does not embrace the Enlightenment idea of progress: “First, there was that, then there was this, and this is better than that.” Nor does it reflect a fatalistic view that civilization as we know it is being flushed down the toilet. Nor does it argue that history is “just one damned thing after another.”

Pérez draws on Mark Twain’s insight that “History never repeats itself, but it often rhymes.”

Her main thesis is that disruption is not a new phenomenon. There has been a repeating pattern of massive disruption that has occurred regularly over the last 250 years at intervals of around 50-60 years. When a transformational technology appears, an explosion of energy can occur, as the existing ways of operating are disrupted by those who have mastered the new technology. New businesses prosper and old ways of doing things collapse and vanish. There is a huge expansion of investment driven by the financial sector. There is often over-investment, as wealthy investors begin to expect outsized returns and seek to extract rents. The resulting bubble in due course bursts. If society is able to rein in the financial economy and refocus it on the real economy of providing goods and services, enduring prosperity can occur. If not, society can slide into lasting decline with little or no real growth and increasing inequality.

By adopting a much longer time horizon and a multi-disciplinary perspective, her book helps us see how societies have made choices. When we look at very long time periods, we can see that the choices form patterns. Some societal choices have led to disaster. Others have led to lasting success. By understanding the choices that prior societies have made and their consequences, we can make better choices among the options now facing us.

She identifies five main eras where this has occurred.

The Canal Mania of the 1790s

In first industrial revolution, beginning in the 1770s, mechanized factories began to transform the rural English economy. There was a rapid expansion of roads, bridges, ports and canals to support the growing flow of trade. In the 1790s, a Canal Mania emerged, as money flowed in to fund the exciting New Technology—canals–including hot money seeking refuge from the French Revolution. The investments funded canal after canal, including those that weren’t needed as well as those that were. The mania continued until the Canal Panic of 1797, after which the real economy took the lead once again. There was a lot of waste and pain, but in the end, the mania funded the infrastructure that remade the English economy.

The Rail Mania of the 1840s

Then there was the English Rail Mania of the 1840s. Sparked by transformational impact on society of rail travel, there was an amazing investment boom in railways. Everyone wanted to invest in this exciting “New Economy”. That is, until the Rail Panic of 1847. During the frenzy, some people became very rich while others went bankrupt and the poor were left behind. When the dust settled, England had built far more railways than could possibly be used. There followed a calmer period in which the overbuilt rail network was rationalized. The Rail Mania involved a lot of waste and pain but it was not all bad: it had funded infrastructure that once again remade the English economy.

The Steel Mania of the 1880s

After a period of relative economic calm, as the economies of the US and Germany moved to the fore, there was the Steel Mania of the 1880s and 1890s. At this time, the hot new technology was steel. A huge transformation of the world economy was under way with transcontinental trade and travel, accompanied by international telegraph and electricity.

Again, there was excited talk of “a New Economy”. Financial markets received a massive infusion of cash as money sought to make money out of money. Everyone wanted to be part of it. That is, until a series of crashes came in various forms in the US, France, Italy and Argentina. Chastened by the crashes, the financial sector in the US and Germany returned its focus for a while to financing the real economy, which stabilized things for a period. (The result was less happy for Argentina which ceased to be a major player in the world economy.) The Steel Mania involved a lot of waste and pain, but it funded the infrastructure for the new global economy.

The Roaring 1920s

Then in the early parts of the 20th Century, investors became excited by the prospects of mass production and Henry Ford’s auto industry that had the potential to once again transform society. Financial wizards appeared in droves to take advantage of the opportunities. By the 1920s, the stock market had swollen to become the engine moving the US economy. Investments were “guaranteed to grow” in an unending bull market. Everyone wanted to be in on it. That is, until the inevitable collapse came in 1929.

The ensuing recession was deep and prolonged, until the financial sector, with the “encouragement” of legislation like the Glass-Steagall Act, was reconnected with the “boring” real economy of firms producing goods and services for real customers. It took a while for the reconnection to take place. When it did, it, along with the World War, enabled a kind of “golden age” in the US economy in the 1940s and 1950s. (Things ended less happily for Germany, which had pursued a state-run economy and military expansion.)

The Computer/Internet Revolution: 1971-

In 1971, the first commercially available microprocessor that could make calculations on a silicon chip was introduced. Although practically no one realized it at the time, this was “the big bang of a new universe of all-pervasive computing and digital communications”. The chips were powerful and cheap. They opened innumerable technological and undefined possibilities. They would transform the way people lived and worked around the world. When the Internet appeared in 1994, the effect became exponential.

In the decades that followed, fortunes were made and lost as part of the transformation. Billionaires were created. The proof that a “New Economy” had arrived was found in the good times of the prosperous 1990s. New profit possibilities appeared at every turn. Making money became a subject of universal interest as everyone rushed to take advantage of the new investment opportunities.

Emboldened by the amazing gains that were possible from the new technology, the financial sector’s investments went far beyond technology. It explored making money from money. The returns were amazing, but alas, they were unsustainable. The dot-com bubble burst in 2000, sparking the equivalent of a “nuclear winter” over Silicon Valley.

The Silicon Valley party seemed to be over. The “wizards” of the dot-com era were forced to sober up after an era of “irrational exuberance”. Computers might be transforming society, but it turned out that this “New Economy” was governed by some of the fundamentals of the Old Economy: customers and profits still mattered.

Yet despite the pain and waste caused by the bursting of the bubble, when it was over, valuable physical and institutional infrastructure for the new economy of computers and telecommunications had been put in place. Massive amounts of fiber optic cable had been laid. Firms had modernized their computer systems. In Silicon Valley, a vast social network had been built that could foster the next generation of economic players like Apple [AAPL], Amazon [AMZN], Salesforce [CRM] and Facebook [FB]. The process had been difficult, but in the end, the productive institutions of society had been remade.

A new bubble: real estate 2001-2008

By 2001, a kind of nuclear winter had come over Silicon Valley. But in the financial sector, things were different. The appetite for the amazing gains from great risk-taking remained unabated. During the dot-com frenzy, the financial sector had become disconnected from the real economy. The financial sector was no longer interested in the “boring” returns that came from producing goods and services for real customers. So the sector sought further new ways to get exceptional returns by making money out of money.

Within a few years, with the indulgence of the Federal Reserve, the financial sector was once again creating amazing gains from real estate, which were also, alas, unsustainable. When the crash came in 2008, Wall Street was able to avoid the “nuclear winter” that had afflicted Silicon Valley, with the help of a government bailout of the big banks.

Main Street was not so lucky. Large numbers of small and medium enterprises went bankrupt. Jobs were lost. Savings were destroyed. Real property values plunged. Houses went underwater and mortgages were foreclosed. Median incomes declined.

A large stock of unneeded housing had been built, but it was largely unproductive investment. Unlike the dot-com bubble with its excessive investments in fiber optic cable and start-up companies, the housing bubble left the economy in no better position to move forward or compete internationally. The housing that had been built was pure consumption that people couldn’t afford. Unlike the dot-com bubble, which in some ways had been a constructive bubble, the housing bubble had few positive elements, except for the financial ‘wizards’ who personally benefited from it. For the next five years, the stock of unused housing sat like a dead weight on the economy, holding it back.

But the appetite and expectation of extraordinary returns was still there. As Kevin Warsh and Stanley Druckenmiller point out in the Wall Street Journal, “Corporate chieftains rationally choose financial engineering—debt-financed share buybacks, for example—over capital investment in property, plants and equipment. Financial markets reward shareholder activism. Institutional investors extend their risk parameters to beat their benchmarks… But real economic growth—averaging just a bit above 2 percent for the fifth year in a row—remains sorely lacking.”

As a result, the economy has remained in the Great Stagnation, running on continuing life support from the Federal Reserve. Large enterprises still appear to be profitable. The appearance, if not the reality, of economic well-being has been sufficient to make the stock market soar.

A set of causal mechanisms

Pérez’s book explains that in these five relatively productive bubbles (canals, rail, steel, mass production, and computers), clusters of innovations have come together to create technological revolutions (disruptions), with astonishing new profit possibilities for those with eyes to see and money to invest.

This in turn gives rise to a financial frenzy, with an expectation of high returns and an over-investment in new profit possibilities. Controls on the financial sector are relaxed and a casino economy emerges. Hot money not only exploits the real opportunities created by the new clusters of technology but also sets out to “make money out of money”. The financial sector takes over, while the real economy, with its “boring” returns, is left behind. People begin to think that the extraordinary returns of the over-heated “New Economy” will continue in perpetuity.

The winners in the casino economy get richer and richer while most miss out: income inequality worsens. The financial frenzy pursues wasteful chimeras; greed and scams are rampant. Eventually a big financial crash—or series of crashes—occurs and the large parts of the economy come tumbling down. But in the process, genuinely better ways of organizing, managing and consuming have been put in place as a result of investments in the new technologies and institutions and the changed way of managing them.

If the crash is severe enough and the political leaders are wise enough, new institutional arrangements stabilize the economy and support the new modus operandi. The real economy is back at the center of the economy, with the financial sector in support. When this happens, a kind of “golden age” may follow, where economic growth rates are moderate but steady but the benefits widely shared. Wide segments of the population prosper and income inequality diminishes.

If the crash is not severe enough to awaken society from its illusions of perpetual exponential returns, or society’s leaders are not wise enough to put in place the institutional changes needed to rein in the rampaging financial sector, then various kinds of national decline can ensue.

The casino economy may continue, with a deterioration of the real economy, worsening income inequality, and persistent financial crashes; or

There may be an over-reaction to the excesses of the financial sector so that regulation stifles the financial sector, thus crippling the future evolution of the real economy; or

The political arrangements may lead to a state-run economy with an extended decline (e.g. Nazi Germany).

What’s different this time?

Despite similarities, no crisis is exactly alike. Reconnecting the financial sector to the real economy is proving more difficult now than before for a number of reasons.

The disruptions caused by the new technology now—computers, Internet, new materials, and new methodologies–are larger and longer-lasting than in any of the the previous disruptions caused by canals, railroads, steel and the like. There is no sign of any slowdown.

The financial sector is now global in scale; and almost too large for any single government to regulate.

The philosophy of “making money out of money” is armed with an economic theory that has overtones of a religion: that the purpose of a firm is to maximize shareholder value.

The banks and big business are nurtured by a government that believes that they are too big to fail and too important to punish for wrongdoing.

Managers of large firms and the banks have found ways to participate in the casino economy and benefit from massive financial incentives to continue making money out of money. As Upton Sinclair wrote, “It is difficult to get a man tounderstand something, when his salary depends upon his not understanding it.”

The underlying disease: maximizing shareholder value

Lepore is right to say that history can provide a useful perspective on business but it needs to be seen from a longer time horizon, and with a much wider-angle lens. Disruption isn’t new, but what is new is the pervasiveness of it and the fact that the usual financial frenzy and the consequent disconnect between the financial sector and the real economy are being driven by a deadly economic theory–shareholder primacy.

If big business and their managers, with the support of the financial sector and the Fed, continue to focus on making money out of money for themselves, we can look forward to increasingly severe crashes and overall economic decline.

If instead society decides that business should focus on the real economy in creating steadily expanding value for customers with real goods and services and reducing risk for an ever wider circle of citizens and enterprises, we could enjoy an era of lasting prosperity.

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How can you say that the root cause of the problem is the “maximize shareholder profit” when you acknowledge there is such a huge collusion (to the tune of trillions) between the State (via the Fed and the Fannie and Freddie, in Europe and Japan via Central Banks) and the financial sector?

From a management and educational perspective, you’re right.But isn’t central banking, fractional reserve, and useless norms the main problem, from a political/societal point of view? (Basel, SOX, etc. They just grow the compliance business and lead to more intricate financial tools with even higher risks, central banks provide the “free cash”).

Thanks for your comments. I agree that the logic is a bit cryptic at the end of the article, and it would need to be read in conjunction with the other articles that are linked there to understand the full logic.

As I say in the article, I agree that the central banks handing vast amounts of cheap money to the big banks and firms to be used in share buybacks and gambling in the derivatives casino is a huge part of the problem. What I was implying that those actions also rest on the belief that if big banks and firms are making profits, then that is good for the economy and so they should go on handing over the cheap money. Ultimately those actions also rest on the shareholder primacy theory.

The article by Kevin Warsh and Stanley Druckenmiller is questioning this whole philosophy, which is a good sign. Business, banks and regulators and society as a whole need to be focused on a different goal related to nurturing the economy of real goods and services, not stoking a machine that makes money out of money for managers and shareholders. This is as much a political and social problem as it is an economic or technical or management problem.

Other societies in time past have been able to make decisions to change things. Whether ours can remains to be seen.